Following suit with the record-breaking performance by stocks, many of our subscription trading services finished strong in 2017. In particular, though, our credit spread-focused Wealthbuilder program actually wrapped up the year with a perfect record, as every single trade recommended during the 12-month stretch expired a winner.
To find out more about this remarkable 100% win rate, we spoke with Schaeffer's Senior Market Strategist Joe Bell, who's been our lead trader on Wealthbuilder for years. Keep reading to get his pro take on writing puts in a low-vol environment, the best technical indicators for credit spreads, when to sell premium on both sides, and finding opportunities when fear is spiking.
With the stock market hitting record highs, is it fair to say that 2017 was a pretty "safe" year to be selling puts?
Joe Bell: The stock market hitting record highs might not be the best benchmark for the safety of the credit spreads in Wealthbuilder throughout the year. In fact, the hope for this type of strategy is that it is not correlated with the U.S. broad market's annual performance.
One major point to note is that the time frame for one of our trades is typically four to six weeks. When we are not in positions, the portfolio is in cash. The other important thing to remember is thatthis specific strategy trades options on ETFs across the asset spectrum. For example, this year some of the ETFs used were VanEck Vectors Gold Miners (GDX), Energy Select Sector SPDR (XLE), iShares Russell 2000 Index (IWM), SPDR S&P 500 ETF Trust (SPY), iShares Barclays 20+ Year Treasury Bond (TLT), PowerShares QQQ Trust (QQQ), and Utilities Select Sector SPDR Fund (XLU).
Each of these ETFs represent different segments of the market. Some of them performed poorly, and some performed well for the year. It came down to identifying times when I felt implied volatility was high, and times when I felt confident about the probability of the future price action of each ETF.
So, just looking at the overall performance of the broad stock market may not always reflect how well or how poorly a premium-selling strategy fared overall. This would depend on the short time frames and diversity of different ETFs traded throughout the year.
Were there any particular challenges with this strategy, expected or otherwise?
It was challenging this year because implied volatility is near historic lows. Some may think that with low implied volatility, it would make it less appealing to sell premium. The important factor to remember is that you're always looking for the relationship between implied volatility and your expected volatility of the underlying.
The other very important part of trading credit spreads and iron condors is which strikes you select and what your outlook is for the underlying. For example, if I sell an out-of-the-money put spread, I could be wrong about volatility. However, if the underlying security finishes above the strike I sold, I profit. It's like any other strategy and ultimately comes down to your ability to accurately predict future price action enough times to outweigh the times when you are wrong.
When researching potential credit spread trade candidates, what are you looking for in terms of technical support?
This really depends on the underlying instrument and the trade. In general, I will use trendlines, volume, price-level support and resistance areas, moving average convergence divergence (MACD), Relative Strength Index (RSI), and moving averages. In addition, I utilize candlestick chart patterns to identify times when buying or selling pressure is pent up or looks poised to move in one direction or the other.
Outside of technical indicators, I also look at option open interest and option activity around the certain strikes to identify areas where there could be future potential transaction volume that acts as support/resistance. Much of that is on the price side of things.
As far as implied volatility, I tend to see mean-reverting behavior. Often, when implied volatility reaches extremes, the eventual future volatility is less than it would imply. Using envelopes and/or Bollinger bands for implied volatility is one way to identify these tradable extremes.
You traded GDX credit spreads in January, and followed up with a GDX iron condor in March. What type of factors or indicators motivate you to favor one strategy over the other?
It really just comes down to my outlook for the underlying ETF or index. There could be technical drivers -- such as support/resistance, momentum indicators, and overbought/oversold signals -- and sentiment factors that might influence my analysis.
From an options perspective, it also depends on the relative value of calls and puts on that security. For example, sometimes put prices are much more expensive than call prices, so it doesn't make sense to sell premium on both sides like an iron condor.
You recommended a SPY credit spread on April 12 -- the day SPY closed below its 50-day moving average for the first time since the post-election rally in stocks began. What was behind that recommendation?
The 50-day moving average was still trending higher, which indicated the intermediate trend was still up. The ETF had been in a strong uptrend, though, and the close below this area sparked a lot of fear from many participants. SPY was also trading near its lower Bollinger band, which had signaled good and long opportunities during the past several months. Plus, the CBOE Volatility Index (VIX) was at its highest level in six months, and at nearly three times the value of the recent historical volatility.
We track bullish and bearish option activity on three major U.S. option exchanges, as well. Based on our data, the number of bearish puts bought to open during the previous 10 trading days outweighed calls by a ratio of 1.60. This is the type of fear and expensive premiums I like to sell into.
The good thing about this credit spread is that it doesn't require you to be a day trader and pick the exact bottom on the exact day. I've sold a put credit spread that was nearly 4% below the current SPY levels. If the SPY continued its momentum lower, it still had plenty of other technical areas of support that might have brought buyers to the table.
Another SPY put spread was opened on Aug. 10, when the VIX shot up 44% to set its 2017 closing high. Were you betting the volatility spike -- largely driven by nuclear fears -- was overdone?
This was another example of the type of spikes in fear that you see in the market. The good thing for a patient premium seller is that these overly emotional reactions to things can present opportunities. All of SPY's major trendlines were moving higher, the uptrend was well intact, and it was trading just above its 40-day moving average. The ETF was actually only about 1% off its all-time high, and yet we saw a spike in implied volatility that sent option premiums to their highest levels in several months.
The $240 area was also a previous support area below the shares, which I felt could bring buyers to the table on any additional selling. The rate at which speculators were buying bearish puts relative to calls was also higher than 87% of the readings we had seen during the past year. Option premiums were very highly priced, and the opportunity to sell out-of-the-money put spreads were highly attractive at that point.
You had a couple of successful IWM spreads in 2017, too. What was the key to playing the small-cap tracker over the past year?
IWM lagged other market sectors in 2017, so entry points for trades had to be precise. The good thing, from a premium-selling perspective, is thatIWM was in a nice trading range between January and August. So, its underperformance created some strong technical support and resistance levels that could be leaned on for collecting premiums. We did a successful IWM bullish credit spread in March when it was trading near the bottom of that range I mentioned.
The other position on IWM was an iron condor in January. The IWM had entered 2017 on the heels of an incredibly strong November rally of more than +17%. It was in the early stages of a trading range in January, and the initiation of the iron condor allowed us to capitalize and profit during a period where long-term investors would normally be sitting on the sidelines or holding positions that are flat.
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